A little more than a year ago, people started to worry that mortgage holders who were underwater but could still afford mortgage payments would just walk away from their homes and, in the process, send real estate prices even lower.
But historical data, plus the fact that nobody seems to have actually documented widespread cases of walk-aways (granted that's not necessarily an easy task), reduced concerns over a potential jingle-mail problem.
Now Stan Liebowitz of the University of Texas at Dallas purports in a WSJ op-ed to have data showing that the walk away decision is the biggest driver of foreclosures during the current cycle. He considers the following to be clear evidence that home owners with no skin in the game are making the rational decision to walk away:
A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures...
What about upward resets in mortgage interest rates? I found that interest rate resets did not measurably increase foreclosures until the reset was greater than four percentage points. Only 8% of foreclosures had an interest rate increase of that much. Thus the overall impact of upward interest rate resets is much smaller than the impact from equity.
To be sure, many other variables -- such as FICO scores (a measure of creditworthiness), income levels, unemployment rates and whether the house was purchased for speculation -- are related to foreclosures. But liar loans and loans with initial teaser rates had virtually no impact on foreclosures, in spite of the dubious nature of these financial instruments.
There are at least a couple of things to touch on here. First, the "simple statistic" Liebowitz presents is highly misleading. Here's why:
A group of Boston Fed researchers studied the poorly-performing Massachussets housing market in the early in 1990's and found that just 6.5 percent of underwater borrowers wound up having their homes foreclosed on.
How does that compare with the current downturn? Liebowitz doesn't include a similar figure, so let's do a rough estimate. According to RealtyTrac, about 1.6 million homes had a foreclosure filing in the second half of 2008, the time period Liebowitz examines. Of this group, 755,000 can be assumed to have been underwater using Liebowitz's 47% figure. According to Zillow (and this table), about 20 million homes are currently underwater. Putting that together shows that only 3.8 percent of underwater homes have defaulted.
It's important to point out that the Boston Fed study looked at a 3-year period, so there will no doubt be a rise in the percentage of underwater borrowers who default. But is there any reason to expect it to go much higher than 6.5 percent?
And reading some of Liebowitz's research, it's clear that he's less an unbiased observer than an opponent of government regulation, which he identifies as the primary cause of the foreclosure crisis:
the money for the speculation was made available by lenders who believed the housing and regulatory establishment when this housing and regulatory establishment said that such loans were safe. Since the housing and regulatory establishment consisted of mighty government agencies and highly educated academics, it was not unreasonable for the lenders to assume that the claims made for flexible underwriting standards were correct. Unfortunately, the claims were not correct although most of the housing and regulatory establishment continue to argue otherwise.
That might explain his appearance on the WSJ op-ed page.
In any case, it's not all that clear that walking away is the most "rational" decision for an underwater homeowner. With the economic picture is as gloomy as it currently is, and the government having just bailed out big institutions to the tune of $700 billion, is it crazy for an underwater homeowner to keep paying his/her mortgage and hope for assistance from the government? Moreover, as a recent paper from Charles Calomiris of Columbia University, Stanley D. Longhofer of the Barton School of Business and William Miles of Wichita State University points out, housing is as much of a consumption good as it is an investment. Which is to say, people have an incentive to stay in their home to keep "consuming" housing even if it's value as an asset declines.